Emerging Enterprise Center Blog : Boston Startup Lawyer & Attorney : Foley Hoag Law Firm : Startup Financing, Venture Capital

I recently ran into this interesting question: If you want to use reverse vesting and take advantage of 83(b) in an S Corporation what do you do about (1) tax distributions and (2) built up after tax profits?

In the case of tax distributions, once the shares are issued, the holder will have to pay tax (to the extent that there are taxable profits) pro rata in accordance with his ownership. So, it seems logical that any distributions made to help stockholders pay this tax should also go to the holder of restricted stock on a pro rata basis. If they do not, then the holder of restricted stock will have taxable income and no cash to pay it. Moreover tax regulations require that “S” corporations make all distributions pro rata to all shareholders, including holders of restricted stock (if they have made 83(b) elections), otherwise the IRS could treat the corporation as having an impermissible second class of stock, resulting in loss of the “S” election."

Now, what about the build up of after-tax value in the corporation? A pro rata amount of that build up belongs to the holder of restricted stock. By way of example, if the company makes $1mm of profit and distributes $400K to the stockholders to pay tax liability, there will be $600K of post tax dollars in the company. If the company were dissolved, these post tax dollars would go pro rata to the stockholders. (In the case of an option holder in an “S” corporation, there would be no ownership and no tax burden.) So, when it comes time for a distribution, even if the option holder exercises his options, he does not get the benefit of the after tax dollars – that is to say, he does not take the dollars out tax free. (Nonetheless, the tax regulations described above require that an option holder who exercises his options must share pro rata in any distributions. In this example, if the company distributes the $600K of accumulated post-tax profits, a pro rata portion of the $600K would go the option holder who had exercised his options, even though none of the $600K has been taxed to him. This, of course, reduces the amounts distributable to the other stockholders, so that they would not receive their full pro rata portion of the $600K based on their ownership prior to the option exercise.) Compare this to a holder of restricted stock with reverse vesting. The holder of restricted stock will have incurred taxable income, will have received cash from the company to pay the tax, and will then get a distribution of post tax dollars equal to (in our example) his pro rata share of the $600K.

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One thing that I find many entrepreneurs (particularly first time entrepreneurs) struggle with is the distinction between options and restricted stock and why one would use restricted stock instead of options.  See also the following link:  Stock Options and Restricted Stock.

I think it is fair to say that most, perhaps all, entrepreneurs have heard of options.  But, just in case, options are contractual rights to purchase shares of stock (usually common stock) at a fixed price.  In the employment context, options typically vest over time.  For example, four year vesting is a common provision in a venture financed company.  A typical arrangement would be for options to vest 1/4 on the first anniversary of employment  and 3/4 ratably (monthly or quarterly) over the subsequent 3 years.  This is the arrangement included in the National Venture Capital Association form of Term Sheet. Vesting refers to the right to exercise the option and purchase stock at the option price.  Since the employee cannot exercise options unless they are vested, to the extent that options have value, the employee is motivated to remain with the company and realize that value.

Restricted stock is actual stock (as opposed to options which are a right to acquire stock).  Restricted stock can be made to provide an incentive similar to that of options by requiring, as a condition to the grant of restricted stock, that the employee receiving the restricted stock enter into an agreement providing for "vesting."  In the context of restricted stock, it is often referred to as "reverse vesting" and it works like this:  The employee is granted shares of common stock subject to the condition that the company will have the right to buy back the shares at a trivial price (often par value).  The concept of reverse vesting comes in because the company loses its repurchase rights over time.  So, on the first anniversary of employment the company may loose the right with respect to 1/4 of the shares and so on.  In this way restricted stock mimics options.

Having said all this, there are important tax differences between options and restricted stock.  Options can be incentive stock options or non-qualified options.  Incentive stock options are options that meet certain requirements set forth in the internal revenue code and, if all conditions are met, can provide the option holder with capital gains treatment (as opposed to ordinary income treatment) upon the sale of stock acquired through the exercise of these options.  Among the requirements are that the options be held for at least one year and that the stock acquired upon exercise of the options be held for at least one year.  Since most option holders commonly sell the stock they acquire promptly upon exercise of the option, they rarely achieve capital gains on the excess of the sale price of the stock over the exercise price of the option.  Non-qualified options do not provide the possibility of achieving capital gains treatment on the excess of the sale price of the stock over the exercise price of the option (although you might, depending on how long you hold the stock, achieve capital gains on the difference between the fair market value on the date of exercise of the non-qualified option and the eventual sale price of the stock).

With respect to restricted stock, the holding period for capital gains treatment begins upon the date of grant, if the holder files a so-called 83(b) election under Section 83 of the Internal Revenue Code.  As a result, most employees who are granted restricted stock will achieve capital gains treatment.  The dark lining on this silver cloud, however, is that when you file an 83(b) election you must take the then fair market value of the stock into income (for purposes of income tax) without regard to whether or not it is vested.  So, if the stock has a high value, the employee receiving the stock will have a lot of income and no cash to pay the tax.  If the 83(b) election is not made, then the employee has to take into income the fair market value of each share of stock at the time that it vests.  If the value of the stock is increasing (as with the customary hockey stick projections) you can imagine that the income to be realized could become substantial.  To avoid these situations, use option grants.  However, early in the life of a company, its stock may have little value, with the result that using restricted stock and increasing the odds of getting capital gains upon a sale of the stock may make good sense.

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